Watch Bernanke’s ‘Little’ Inflation Capsize U.S.: Shlaes

A little is all right. That’s the
message Federal Reserve Chairman Ben S. Bernanke has been giving
out recently when asked about the evidence of inflation in the
U.S. recovery.

Sometimes Bernanke doesn’t even go that far. He simply says
he doesn’t see inflation. The Fed chairman recently described
the prospects for price increases across the board as “subdued.”

“Sudden” is more like it. The thing about inflation is that
it comes out of nowhere and hits you. Monetary policy is like
sailing. You’re gliding along, passing the peninsula, and you
come about. Nothing. Then the wind fills the sail so fast it
knocks you into the sea. Right now, the U.S. is a sailboat that
has just made open water, and has already come about. That wind
is coming. The sailor just doesn’t know it.

“Sudden” has happened to us before. In World War I, an
early version of what we would call the CPI-U, the consumer
price index for urban areas, went from 1 percent for 1915 to 7
percent in 1916 to 17 percent in 1917. To returning vets, that
felt awful sudden.

How did it happen? The Treasury spent like crazy on the
war, creating money to pay for it, then pretended that its
spending was offset by complex Liberty Bond sales and
admonishments to citizens that they save more.

Country in Denial

In other words, the Woodrow Wilson administration was in
denial, inflating in all but name. Commenting on one complex
plan to make more money available, Representative L.T. McFadden,
a Pennsylvania Republican, said, “I would suggest that if the
administration believes that inflation of this character is
necessary to finance the war the more direct way would be to
issue the notes direct.”

Or, to return to sailing terms, the Treasury and Fed had
tilted the U.S. monetary craft so far one way that it needed to
lean back the other way before it could right. That leaning was
the true tight money policy of subsequent years, including
deflation of 10 percent and wrenching unemployment.

History has other examples. In 1945, all seemed well:
Inflation was 2 percent, at least officially. Within two years
that level hit 14 percent.

All appeared calm in 1972, too, before inflation jumped to
11 percent by 1974, and stayed high for the rest of the decade,
diminishing the quality of life for whole cohorts. They paid the
higher interest rates needed to reduce the inflation, and got a
house with one less bedroom. Or no pool.

The thing about inflation is that it accelerates. The
acceleration hit storybook levels in the most sudden case of
all, that of Germany in 1922. Many financial analysts thought
the Weimar authorities weren’t producing enough money.

“Tight Money in German Market: Causes of the Abnormally
Rapid Currency Deflation at Year-End,” read a New York Times
headline. The Germans didn’t know it, but they had already
turned their money into wallpaper; the next year would see
hyperinflation, when inflation races ahead at more than 50
percent a month. It moved so fast that prices changed in a
single hour. Yet even as it did so, the country’s financial
authorities failed to see inflation. They thought they were
witnessing increased demand for money.

The greater the denial before, the faster the inflation
accelerates after. Author Daniel Yergin tells the story of a
student in Freiburg who ordered a cup of coffee in a cafe; the
price was 5,000 marks. Then he had another. When the bill came,
it was 14,000. “If you want to save money and you want two cups
of coffee, you should order them both at the same time,” he was
told.

Extreme Example

Germany in the 1920s is always the extreme example. But one
form of denial then warrants comparison to the U.S. today.

Bernanke talks about prices in one area - energy, for
example -- as different from those in the rest of the economy.
The Germans, in their denial, thought their problem was limited
to exchange rates, and that their domestic economy had hope.
Risibly, Chancellor Joseph Wirth tried to tie down prices by
regulating foreign currency. The equivalent, and equivalently
risible, move today is the Ralph Nader effort to get the
administration to push down oil prices.

The reason a little inflation is not all right, and the
reason inflation comes suddenly, is expectations.

The phrase “perception is reality” is overused generally.
But perception can be reality in monetary policy. The bond
market doesn’t act merely on what it sees. It acts on what it
expects of the Fed or the government. And our own Fed has let us
know it’s capable of just about everything, which includes
inflationary monetary policy. Disillusionment can come as fast
as a gust, but building faith that the government won’t inflate
again is like building a new sailboat, a project of years.
Another way to put this is how the central banker Henry Wallich
did. Inflation is like a banana, Jerry Jordan of the Cleveland
Fed quoted him as saying. Once you see one brown spot, it’s too
late.

The reason that markets haven’t jumped yet is that the last
great inflation and correction happened in the late 1970s and
early 1980s, just long enough ago that most adults in the
financial markets don’t remember it.

We can debate whether today’s challenge resembles that
faced in the early 1980s, or something worse. But one thing is
clear: pretty soon, we’ll all be in deep water.

(Amity Shlaes is a Bloomberg View columnist and the
director of the Four Percent Growth Project at the Bush
Institute. The opinions expressed are her own.)